Understanding Fannie and Freddie, a tutorial

Fan and Fred borrow money to make home loans.  As long as homeowners pay them back, Fan and Fred can pay back their own debt.  Essentially, the companies make money by lending at a high interest rate while borrowing at a lower one.

Trouble occurs when Fan and Fred lend to home buyers who DON’T pay their mortgage.  They’ve done this to the tune of hundreds of billions over the past few years.  Though they’ll deny it, a quick perusal of the footnotes of their financial statements shows they’ve engaged in all sorts of risky lending.  And the two companies have used accounting tricks to hide the resulting losses.

So the question naturally becomes: if homeowners don’t pay back Fan and Fred, how do Fan and Fred pay back their own debt?  Well, any normal bank is required to carry lots of extra “capital” for just this reason.  If money they’ve lent isn’t paid back, they have to have reserves on hand to meet their obligations.

But Fan and Fred aren’t normal banks.  And they’ve been allowed to operate with just a sliver of protective capital for years.  Why would creditors continue to lend to Fan and Fred if they clearly don’t have enough capital to cover losses?  Because of the implicit taxpayer guarantee backing their debt.

As “Government Sponsored Enterprises,” the two companies are understood by the capital markets to have an open credit line at the United States Treasury to cover any losses they incur.

Hank Paulson gave Fan and Fred more explicit backing to that credit line on Sept 8th, with a $200 billion bailout.  The tab will likely be larger over time.

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Update:  There’s some confusion as to the government’s new commitment to Fannie/Freddie, which is why many investors in their debt have stopped buying it.  On the one hand, Paulson and other government officials have stressed they stand behind Fan and Fred.  But when asked how far that commitment goes, they hedge:

“What we did say is an effective guarantee because there’s $100 billion backing their equity provided by the U.S. Treasury,” James Lockhart (Fannie and Freddie’s chief regulator) said after the hearing. “That does give them effectively a guarantee of the U.S. government.”

No it doesn’t!  Not if Fannie’s losses are going to eclipse $100 billion.  Already Fannie is saying $100 billion won’t be enough.

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